Annuity Contracts in a 412(e)(3) Plan: How They Fund a Fully Insured Defined-Benefit Plan

When the Annuity-Funding Structure Applies

The exemption depends on the plan as it actually operates, not on its label. Section 412(e)(2)(B) applies when the plan meets section 412(e)(3)(A)-(F) for the plan year. That means:

• the plan is funded exclusively by insurance contracts;
• the premiums are level and annual, running from the start of participation to no later than retirement age;
• plan benefits equal the contract benefits at normal retirement age, backed by a state-licensed carrier only to the extent premiums have been paid;
• premiums have been paid before lapse, or the policy has been reinstated; and
• there is no security interest and no policy loan at any time during the year.

The plan also needs to be a qualified defined-benefit plan under section 401(a). For group annuity contracts, 26 C.F.R. § 1.412(i)-1(c) supplies the parallel conditions.

When the Annuity-Funding Structure May Not Apply

Any single condition can break the structure. A plan that misses a condition falls outside section 412(e)(3), and the section 412(e)(2)(B) exemption no longer covers it. Common ways this happens:

• A loan or pledge. A policy loan outstanding, or a security interest in the contract rights, at any time during the plan year fails condition (E) or (F).
• Unpaid premiums. Premiums not paid before lapse, with no reinstatement, fail condition (D).
• Excess contract benefits. Rev. Rul. 2004-20 describes a plan that "cannot be a section 412(i) plan if the plan holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of the participant's benefits." Separately, section 415(b) caps the plan benefit.
• Contributions above the section 404 limits. These are not deductible as contributed. For life insurance coverage above the participant's death benefit under the plan, Rev. Rul. 2004-20 states that the contributions "are not fully deductible when contributed, but are carried over to be treated as contributions in future years."
• Unequal purchase rights. Rev. Rul. 2004-21 holds that a plan funded in whole or in part with life insurance contracts can fail section 401(a)(4) when highly compensated employees have more valuable rights to buy those life insurance contracts from the plan before distribution.

Compliance Considerations for Annuity-Funded Plans

IRS attention to this plan type is long-standing. The IRS states that it "issued guidance in 2004 and 2005 to stop abuses involving the use of certain specially designed life insurance policies in retirement plans," naming Rev. Rul. 2004-20, Rev. Rul. 2004-21 and Rev. Proc. 2005-25.

Rev. Rul. 2004-20 identifies as "listed transactions" arrangements the same as, or substantially similar to, its Situation 2 when "the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000." The IRS page on fully insured plans states the same $100,000 threshold for a "listed transaction." Listed-transaction status carries disclosure obligations under Treasury regulations, and penalty exposure follows from a failure to disclose. Whether a given plan is such an arrangement is a question of its facts.

Other ongoing obligations include the following:

• Annual reporting. Under 29 C.F.R. § 2520.104-44(b)(2) and (d), a pension plan funded with certain allocated insurance contracts gets an alternative method of compliance for some items but is not exempted "from filing an annual report form."
• Nondiscrimination. The plan needs to satisfy section 401(a)(4), and the coverage rules apply as well.
• Distributions. Section 72(e) applies to an amount received under an annuity contract that is not received as an annuity only "if no provision of this subtitle (other than this subsection) applies with respect to such amount." Where it applies, an amount received on or after the annuity starting date "shall be included in gross income." How a participant's distribution is taxed depends on the payment form, the other provisions that apply and any investment in the contract.

Plan design, contribution levels and deduction amounts for a section 412(e)(3) plan need individual review of the contracts involved by the insurers and a qualified tax professional.

Common Errors in 412(e)(3) Annuity Plan Administration

The exemption is tested for each plan year. Examples:

• Taking a loan or pledging a contract. A policy loan against a contract, or a pledge of contract rights to secure business debt, fails section 412(e)(3)(E) or (F) for the plan year.
• Letting a premium lapse. A premium that lapses without reinstatement fails condition (D).
• Overstating the benefit. A benefit design above the section 415(b) limit exceeds the limitation that section states, whatever the contract provides.
• Equating premium with deduction. Treating the premium amount as the deduction amount ignores the section 404(a) limits and may overlook section 264(a)(1).
• Holding contracts that outpace the plan. Contracts whose benefits exceed the plan's benefits are the pattern Rev. Rul. 2004-20 addresses.
• Unequal purchase rights. Favoring highly compensated employees in rights to buy life insurance contracts from the plan is the pattern Rev. Rul. 2004-21 addresses.
• Skipping filings or testing. Missing annual reports or nondiscrimination testing creates separate problems.
• Misreading the exemption. The exemption covers minimum funding only. Section 401(a) qualification still applies.

Hypothetical Example: Level Premiums and Benefit Determination

This example is hypothetical. It uses round figures, involves no real contract and does not represent any reader's result.

Assumptions:

• One participant enters the plan at age 50.
• The plan's normal retirement age is 65.
• An individual annuity contract calls for a level annual premium of $100,000.
• Under its terms, the contract provides an annual benefit of $90,000 at age 65.
• The plan's stated benefit is also $90,000.

Arithmetic:

1. Premium years: 65 − 50 = 15 years.
2. Total scheduled premiums: 15 × $100,000 = $1,500,000.
3. Condition (C) check: the plan benefit of $90,000 equals the contract benefit of $90,000.

Limits that still apply:

• The exemption applies for a plan year only if all six section 412(e)(3) conditions are met for that year.
• The deductible amount is limited by section 404(a) for the year.
• The $90,000 benefit is tested against section 415(b) for the year in which it is tested.

Actual figures depend on the specific contract, the participant's age and compensation, and the limits in effect for the plan year.

Professional Coordination for a 412(e)(3) Annuity Plan

Several roles meet in one plan. The professionals usually involved are:

• An actuary. Section 404(a)(1)(A) refers to "the funding method and the actuarial assumptions used," so actuarial work is typically involved in measuring contributions.
• A qualified tax professional. This adviser typically reviews the plan document, the deduction position and any listed-transaction or nondiscrimination questions the plan raises.
• The plan administrator. The administrator typically handles annual reporting and nondiscrimination testing.
• The insurer. The insurer issues the contracts and states their premium and benefit terms. Forms, procedures and timing vary from insurer to insurer, and insurance rules vary by state.

The individual-review point in the compliance discussion applies across all of these roles. Premium questions about contracts held outside a plan appear on the site's page on premium deductibility under section 264.